Devulgarized from source: https://www.reddit.com/r/wallstreetbets/comments/5nqwb7/kindof_tldr_on_options/
Please note that this is more of a 'high level' view of everything. IF YOU ARE NEW TO THIS, START BY PAPER TRADING BEFORE ACTUALLY THROWING AROUND REAL MONEY. A site for this can be found by a simple Google search. Wall Street Survivor is one I know off the top of my head that allows you to paper trade options.
First, let's look at a trade. This example was taken from /u/PseudoCupid post 'Rate my YOLO'.
The break down
This image says this: OP bought 76 calls at a 0.61 premium for TLSA which has a strike price of $480 and expires January 19th, 2018.
But what does it MEAN!?
OP basically thinks that TSLA stock price will go over $480 by Jan 19th of next year.
Okay, but what does it REALLY mean?
OP bought 76 calls (aka CONTRACTS). If you think a stock price will rise, you buy a call contract, and if you think a stock price will fall, you buy a put contract. ONE contract represents 100 SHARES.
OP bought 76 contracts, which means his position represents 7,600 shares of TSLA.
He bought these contracts at a 0.61 premium. The premium represents the price you pay for the option to buy/sell one share at a specific price (strike price) before a certain time (expiration). So, if 1 contract represents 100 shares, and the premium represents 1 share, the price for ONE contract costs (100 x Premium). This means that since the premium was 0.61 when OP bought, and he bought 76 contracts, he paid (100x0.61=$61) $61 per contract. Since he bought 76 contracts he paid (76 x 61 = $4,646) $4,636 total for the trade.
Next, we see that the conditions for the contracts are that it expires Jan 19, 2018, and the strike price is $480. This means that OP for each contract he owns, he has the right to buy/sell TSLA shares (exercise the contract) at the strike price specified before the contract expires.
For calls, if a contract's strike price is BELOW the current stock's price, it is considered In The Money (ITM). If it is ABOVE the stock's current price, is it considered Out The Money (OTM). I will go in to more details regarding this later.
When you choose to exercise a contract (in this case, a call option) you own, it allows you to buy the stock at the strike price specific in the contract. This means if the current price of TSLA is at $500/share and the contract has a strike of $480, you can buy TSLA shares at $480. People will usually do this, and instantly sell the shares back at market price for the profit.
What happens if the contract expires?
If a contract is not exercised before the expiration date, it disappears. It is no longer valid, and all the money you paid for it is 100% gone.
Why would anyone buy a contract with a strike price so far off from the current stock price?!
A lot of people trade options (contracts) around the premium.
When a stock price goes up, usually the premiums for calls goes up. This is controlled the same way as the stock price (what people are willing to pay for the contract). So, if OP bought his 76 calls when TSLA was at $200, and now TSLA is at $230, there is a good chance the premium for those contracts has increased. And as we can see from the screenshot, the last bid/ask was at 0.91. OP has made money based on the premium.
If OP was to sell off his contracts (not exercise them), he will make $2,280.
Since he paid $4,636 for the contracts
76 (num of contracts) x 61 (100 shares per contract x 0.61 premium) = $4,636
He can now sell:
76 (num of contracts) x 91 (100 shares per contract x 0.91 premium) = $6,916
$6,916 - $4,636 = $2,280.
OP probably didn't sell yet because he believes TSLA will grow a lot more within the next year, and those premiums will grow a lot more. He is betting TSLA will do good. However, this does not necessarily mean he thinks TSLA will reach $480 since he can sell off the contracts whenever he wants (and they become someone else's problem).
Okay, so where do all these contracts come from?
The contracts come from the open market (aka YOU!).
People write (or 'create') options (contracts) and sell them. If you write an option (contract), you are legally on the line for the shares that you write the option (contract) for... So someone, wrote a promise to OP saying that they will sell them 100 shares (per contract) of TSLA for $480 per share if he chooses to exercise the *option. This is usually facilitate through your broker.
Who determines when the contract expires?
The person who wrote the option (contract) determines the date it expires. However, there is a set cycle of when contracts expire.
Contracts expire on Fridays. Which Friday? Depends. By default, contracts expire on the 3rd Friday of the month. However, it is possible to write contracts for other Fridays during the month. It varies from company to company.
Trading options that expire the Friday of the current week are usually referred to as FD.
How do people lose so much money?
People make bad decisions. But there are a couple ways to lose a lot of money very quickly, like if...
1) You write (create) and sell an option that you do not own the shares for. This is referred to as naked option (Naked call or Naked put). If you don't own the money to buy 100 shares at the current price of a stock, or don't already own the stock, don't be an idiot and write an option.
2) The stock price goes in the opposite direction of what you thought. Volatility is a bitch. If TSLA has a catastrophic failure and drops to $150, those premiums are going to go with it. If they dropped to lets say, 0.31, OP will have lost $2,280 of his $4,636 investment. This can happen pretty quickly in many cases.
3) You forget about the options you own, and let it decay. If the option expires, it's worthless and you lose all the money you invested. As time goes by, premiums slowly drop the closer they get to the expiration date.
Are any strategies to minimize risk while keeping a modest amount of potential profit?
Yeah, I'm kind of tired so I'll link some more reading material..